Study: Hedge Fund Returns Heavily Impacted by Biases

Aug 17 2015 | 3:45pm ET

A recent academic paper has thrown some cold water on the idea that reported hedge fund returns adequately represent the overall performance of the industry. 

The study, titled “Hedge Funds: A Dynamic Industry In Transition", was undertaken by Mila Getmansky of UMass Amhest, Andrew Lo of MIT and Peter Lee of AlphaSimplex Group. Released at the end of July, the paper did not get much media attention until picked up by Bloomberg earlier this week. 

The study focused on several elements of the hedge fund industry, among them whether hedge fund returns carry inherent biases that skew the overall industry’s performance data to make it look stronger than it really is.

Much of the paper’s conclusions come from the fact that hedge fund databases rely on voluntarily reported information, and hedge funds do not typically begin reporting their performance until it is at least competitive with benchmark indices.

Furthermore, new funds add prior-year results to the data when joining a database, and when results stumble, can simply stop reporting data. Such factors can lead to heavy backfill, extinction and survivorship biases in measurements of the overall industry’s performance. 

Adjusting for these factors, the study found that the average annualized return for the hedge fund industry since 1996 falls from 12.6% to 6.3% (the study relied on Lipper TASS data). Skewness, kurtosis, and maximum drawdowns increase significantly after survivor and backfill adjustments, while volatility increases slightly.

The authors determined that once the historical data is adjusted for bias, “hedge funds have not, on average, meaningfully outperformed traditional portfolios of stocks and bonds after fees.” Moreover, on average, they do not routinely generate double-digit returns. 

However, the authors did confirm that as a group, hedge funds have exhibited lower volatility than traditional stock/bond portfolios, and although many are correlated with one another, are a fairly heterogeneous group. 

The paper also addresses two common myths in the alternatives space. “The first myth is that all hedge funds are alike, implying that alternative investments comprise a homogeneous asset class that have similar investment characteristics with returns that move in concert,” the authors state. 

“The second myth is that all hedge funds are unique, implying no commonalities and, therefore, no implications for diversification or systemic risk,” they continue.

The paper is available for download here.

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